ProfessorBainbridge.com

A New Paper by Yours Truly: Don’t Compound the Caremark Mistake by Extending it to ESG Oversight

Posted to SSRN: Don’t Compound the Caremark Mistake by Extending it to ESG Oversight.

Abstract: Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational. 

To promote Board Diversity States are Rampantly Ignoring the Internal Affairs Doctrine

A guest post on Kevin LaCroix's D&O Diary site reports on the status of board diversity legislation at the state level. Money quote:

While California and Washington are currently the only states with mandatory diversity requirements, nearly all of the bills introduced in state legislatures in 2021 have followed that approach – including Connecticut, Hawaii, Massachusetts, Michigan, New Jersey, and Oregon. Illinois and Maryland require only disclosure of boardroom demographics, but do not mandate any level of board diversity. Colorado and Pennsylvania have non-binding diversity requirements, urging companies to act on their own; Ohio has introduced similar legislation.

Some striking points:

• Maryland's mandatory disclosure statute applies to both for-profit and not-for-profit entities. 
• New York's mandatory disclosure bill applies to both public AND privately held companies authorized to do business in the state.
  • If adopted, Ohio's non-binding resolution urging board diversity also applies to both public and privately held corporations that are "doing business" in the state.
• 9 of the 11 statutes apply not just to companies incorporated in the adopting state but also to companies headquartered in the state
  • As noted, New York applies to any corporation--whether incorporated in New York or not--authorized to do business in the state
  • As noted, Ohio's applies to all companies "doing business" in Ohio, whether incorporated there or not.

All 11 have thus tossed the internal affairs doctrine out the window. As regular readers know, I believe that the internal affairs doctrine is both sound public policy and a constitutional requirement. As such, my view is that all of these statutes are constitutionally suspect.

As always, the wisdom and constitutionality of such statutes if limited to companies incorporated in the adopting state is a matter as to which I have no opinion.

Keith Paul Bishop Reports on a "New Challenge Filed To California Board Quota Laws"

Here:

Earlier this month, a Texas non-profit membership association filed a complaint in the United States District Court for the Central District (Western Division) of California, Alliance For Fair Board Recruitment v. Weber, Case No. 2:21-cv-05644-RGK-RAO (July 12, 2021).  Unlike an earlier court challenges, this lawsuit takes on both SB 826 and AB 979. ... 

This new challenge differs from the others because it takes on both requirements and argues that both quota requirements are contrary to the "internal affairs doctrine".   The plaintiff asserts:

California's race and gender quota laws expressly apply "to the exclusion" of the laws of the state of incorporation.  Cal. Corp. Code §§ 2115.5(a), 2115.6(a).  In other words, these board laws assert that they override other states' laws governing corporations incorporated in their own states.  Therefore, California's "diversity" laws violate the internal affairs doctrine.

The plaintiff's complaint also differs in that it claims associational standing since it is brought on behalf of an association.  

As regular readers know, I am agnostic on the equal protection claims against these statutes but am in full agreement with plaintiffs that, as drafted, they are unconstitutional under the internal affairs doctrine because they purport to apply the law of a state other than the state of incorporation to an internal affair of that corporation. See Internal Affairs, the California Board Gender Quota Law, and Chin v. CH2M Hill Companies, Ltd.

Ann Lipton on whether Elon Musk Controls Tesla

Recommended read.

Federalist Society CLE Program on Board Diversity Requirements, Featuring Yours Truly

Register here.

What law applies to veil piercing claims?

Keith Paul Bishop reports:

In an opinion issued last week, U.S. District Court Edward M. Chen ruled that Ohio law applied to an alter ego claim against the members of an Ohio limited liability company.  Greenlight Sys., LLC v. Breckenfelder, 2021 U.S. Dist. LEXIS 120288.   He found support for his ruling in California Corporations Code Section 17708.01 which provides:

(a) The law of the state or other jurisdiction under which a foreign limited liability company is formed governs all of the following:

(1) The organization of the limited liability company, its internal affairs, and the authority of its members and managers.

(2)The liability of a member as member and a manager as manager for the debts, obligations, or other liabilities of the limited liability company.

Bishop goes on to ask why the court ignored "the Court of Appeals' holding in Laborers Clean-Up Contract Admin. Trust Fund v. Uriarte Clean-Up Service, Inc., 736 F.2d 516, 523, (1984): 'In considering whether to disregard the corporate form, we apply federal substantive law, although we may look to state law for guidance.'"

Interesting question.

 

Why do boards get to spend corporate money to fight off proxy contests?

A friend of mine who teaches constitutional law took an interest in more important matters when he read about the recent proxy fight at ExxonMobil. He asks:

Why is it legal for Exxon’s management or the majority of Exxon’s current board to spend shareholder dollars to tell shareholders not to vote for other candidates?

On level, the answer is "because the courts say so." As I explain in my book Corporate Law (Concepts and Insights):

In theory, incumbent directors do not have unbridled access to the corporate treasury. In practice, however, incumbents rarely pay their own expenses. Under state law, the board of directors may use corporate funds to pay for expenses incurred in opposing the insurgent, provided the amounts are reasonable and the contest involves policy questions rather than just a “purely personal power struggle.” [E.g., Rosenfeld v. Fairchild Engine & Airplane Corp., 128 N.E.2d 291 (N.Y.1955), reh’g denied, 130 N.E.2d 610 (N.Y.1955).] Only the most poorly advised of incumbents find it difficult to meet this standard. The board merely needs have its lawyers parse the insurgent’s proxy materials for policy questions on which they differ. Such a search is bound to be successful: if the insurgent agrees with all of management’s policies, why is it trying to oust them?

In contrast, insurgents initially must bear their own costs. Insurgents have no right to reimbursement out of corporate funds. Rather, an insurgent will be reimbursed only if an appropriate resolution is approved by a majority of both the board of directors and the shareholders. [E.g., Steinberg v. Adams, 90 F.Supp. 604 (S.D.N.Y.1950); Grodetsky v. McCrory Corp., 267 N.Y.S.2d 356 (Sup.Ct.1966).] If the incumbents prevail, of course, they are unlikely to look kindly on an insurgent’s request for reimbursement of expenses. In effect, the insurgent must win to have any hope of getting reimbursed.

On a deeper level, the question is why have the courts so held? The Rosenfeld court explained that:

If directors of a corporation may not in good faith incur reasonable and proper expenses in soliciting proxies in these days of giant corporations with vast numbers of stockholders, the corporate business might be seriously interfered with because of stockholder indifference and the difficulty of procuring a quorum, where there is no contest. In the event of a proxy contest, if the directors may not freely answer the challenges of outside groups and in good faith defend their actions with respect to corporate policy for the information of the stockholders, they and the corporation may be at the mercy of persons seeking to wrest control for their own purposes, so long as such persons have ample funds to conduct a proxy contest.

Id. at 293.

The Delaware Chancery Court similarly explains that:

The report of the case of Pell v. London & North Western Ry. Co., [1907] 1 Ch. Div. 5, contains discussions by the three Lord Justices who sat in the case, which very persuasively demonstrate that such expenditures are entirely proper. The underlying reason is given by them as this-that inasmuch as the stockholders are called upon to express their judgment upon the soundness of a questioned policy, it is in the interest of an intelligent decision by them that they should be advised by the responsible managers of the corporation who formulated the policy what were the considerations which induced their approval; and that it would be highly unreasonable to require that the directors should personally defray the expense incident to the performance of a duty which rested upon them to lay before the stockholders the information which is requisite for an informed decision in turn on their part. Where the question in one of a policy to be adopted, the judges in the English case just cited took the view, and very reasonably so, that the corporation was under a duty to advise the stockholders, whose approbation or disapproval was to be determinative, of the reasons for the policy's adoption, and that in such a case the directors are to be regarded as having that corporate duty laid upon them. Any expense incident and reasonably necessary to perform that duty, is an expense incurred in the interest of the corporation and therefore properly chargeable to it.

Hall v. Trans-Lux Daylight Picture Screen Corp., 171 A. 226, 227 (Del. Ch. 1934).

Professor Melvin Eisenberg offered a slightly different explanation:

In considering this problem two economic facts must be viewed in conjunction: (1) Proxy fights involve a lot of money ... and most of the expenses are probably incurred in connection with just those techniques that have the least informational content; (2) While corporate directorships are unquestionably valuable, in themselves they do not normally pay very much money. ... Putting these two facts together, most outside directors and many inside directors ordinarily could not be expected to defend a proxy fight out of their own pockets. Thus a rule which precluded management from using corporate resources for such campaigns might tend to drive corporate offices into the hands of those who are ready and able to pay for such campaigns. Management access to the corporate proxy machinery may therefore be justified, not because the election of directors is a board function — it is not; and not because typically the issues are policy issues and the expenses are incurred for the purpose of informing the shareholders on these issues — they are not; but because in the long run the shareholders and the entire economy might suffer if management had to choose between paying for proxy campaigns out of its own pocket or throwing in the towel.

Melvin Aron Eisenberg, Access to the Corporate Proxy Machinery, 83 Harv. L. Rev. 1489, 1499–500 (1970).

So take your pick:

1. Allowing the board to spend corporate funds allows them to defend the corporation from potential bad actors.
2. It ensures that shareholders are fully informed.
3. It allows persons of modest means to serve as directors.

Ninth Circuit holds shareholder has standing to challenge California board diversity quota law

Bloomberg reports:

An OSI Systems Inc. shareholder has standing to challenge a California law requiring public corporations headquartered in the state to have a minimum number of women on their boards of directors, the Ninth Circuit ruled Monday.

California Senate Bill 826 “requires or encourages” individual shareholders of public companies to vote for female board members, the U.S. Court of Appeals for the Ninth Circuit said. As an individual shareholder of California-based OSI, Creighton Meland has standing to argue that the law requires him to discriminate on the basis of sex in violation of the 14th Amendment, the court said.

The full text of the opinion is here. The summary explains:

Plaintiff alleged that Senate Bill 826 (SB 826) requires shareholders to discriminate on the basis of sex when exercising their corporate voting rights, in violation of the Fourteenth Amendment. The panel held that plaintiff plausibly alleged that SB 826 requires or encourages him to discriminate based on sex. Plaintiff therefore adequately alleged an injury in fact, the only Article III standing element at issue, and thus had Article III standing to challenge SB 826.

The opinion summarizes the relevant legal rule as follows:

... we have long held that “[a] person required by the government to discriminate by ethnicity or sex against others has standing to challenge the validity of the requirement, even though the government does not discriminate against him.” Monterey Mech., 125 F.3d at 707. ...

We have subsequently relied on Monterey Mechanical’s determination that a person required or encouraged to discriminate on the basis of a protected class, “even if the beneficiaries [of the discrimination] are members of groups whose fortunes we would like to advance,” id. at 708, has suffered a direct personal injury sufficient to confer standing.

California objected that the bill affects only corporations; not shareholders. But the 9th Circuit rejected that argument:

Here, corporate shareholders are an object of SB 826. As a general rule, shareholders are responsible for electing directors at their annual meetings. E.g., Cal. Corp. Code §§ 301(a), 600(b). OSI is no exception. Thus, the only way a person can be elected to OSI’s board is if a plurality of shareholders vote in favor of the nominee at an annual shareholder meeting. OSI itself has no authority to elect its own board members. For SB 826 to hasten the achievement of gender parity—or indeed, for SB 826 to have any effect at all—it must therefore compel shareholders to act. Accordingly, the California Legislature necessarily intended for SB 826 to require (or at least encourage) shareholders to vote in a manner that would achieve this goal.

California also argued that shareholders will not be forced to vote for female directors, but the 9th Circuit rejected that argument as well:

A reasonable shareholder deciding how to vote could not assume that other shareholders would vote to elect the requisite number of female board members. Therefore, each shareholder would understand that a failure to vote for a female would contribute to the risk of putting the corporation in violation of state law and exposing it to sanctions. At a minimum, therefore, SB 826 would encourage a reasonable shareholder to vote in a way that would support corporate compliance with legal requirements. Indeed, the California Legislature must have concluded that SB 826 would have such an effect on individual shareholders; otherwise, if each individual shareholder felt free to vote for a male board member, SB 826 could not achieve its goal of reaching gender parity. ...

California’s argument that SB 826 does not require a shareholder to discriminate, because the law does not impose monetary sanctions directly on shareholders, also fails. A law may require or encourage action whether or not it imposes a monetary sanction for noncompliance.

All of this is way outside my wheelhouse, of course. My own view remains limited to the issue of whether the law is constitutional under the internal affairs doctrine. As regular readers will recall, I believe the law is not constitutional thereunder. 

Keith Paul Bishop comments:

Although I agree with the Court of Appeal's conclusion, the opinion begins with an erroneous description of the law, stating that SB 826 "requires all corporations headquartered in California to have a minimum number of females on their boards of directors".  The law applies only to "publicly held domestic or foreign corporations", not all corporations. 

Kevin LaCroix has a very detailed review of the case and issues. He points out that:

The appellate court’s action has implications both for the board gender diversity statute and the more recently adopted board racial diversity statute, which has also been challenged in court. ...

The appellate court’s ruling that Meland has standing means only that the lawsuit now goes back to the district court for further proceedings. The appellate court’s ruling does not mean Meland’s claims are meritorious, or that the statute is unconstitutional. ...

A complete review of the picture surrounding the legal challenges to SB 826 also requires a discussion of the separate state court challenge to the California board gender diversity statute.

Go read the whole thing.

Guest Post: Russell Powell responds to my comments on his new paper Spirit of the Corporation

I am delighted that Russell Powell offered a guest post responding to my recent comments on his paper Spirit of the Corporation. His comments follow:

Thanks to Professor Bainbridge for taking an interest in and recommending my article “Spirit of the Corporation,” which was presented at the recent Berle Symposium (this year focused on religion and corporate law). His question, whether considering spirit as opposed to corporate culture does any significant work, is one that was raised at the symposium, and I acknowledge that the ideas are overlapping. I do not object to readers choosing to consider my formulation of corporate spirit a variation of corporate culture discourse. That said, in this work I am attempting to seriously engage theological traditions in their own contexts (Catholicism and broader Christianity, in particular). In my symposium presentation, I explained that I was attempting to use Rawlsian method regarding public discourse by presenting my private, religiously-based reasons along with parallel, secular reasons. Professor David Skeel appeared to take a similar approach with his very interesting paper “The Corporation as Trinity.”

I am comfortable with the range of definitions for spirit in the paper, but I do not focus on corporate culture explicitly. There is obviously a rich and diverse body of literature on corporate culture from a variety of fields over the past fifty years. Many of those descriptive and normative approaches would be consistent with my characterization of corporate spirit. However, I would argue that there are distinctions, even from a purely secular perspective. Definitionally, I am uncomfortable completely conflating spirit with culture. Is the spirit of the law (its essence or ideal) completely synonymous with legal culture or the culture of law? I think of corporate culture as the granular social facts that shape the tacit values, customs, traditions, and meanings within a particular business organization. In much of the business literature, there is an emphasis on internal mechanisms, policies and incentives, while legal scholars tend to emphasize the role of external rules. Corporate spirit might be considered a broader, inclusive category which focuses on the orientation of the entity toward particular goods, rather than the myriad mechanisms that contribute to that orientation. Although changing internal structures and external incentives can impact corporate culture, I wonder whether religious traditions that emphasize the need for internal transformation may contribute a helpful insight regarding the necessity for internal transformation as an important predicate for institutional reform.

Like Professor Bainbridge, I do not attribute to corporations a soul. From a Christian scriptural perspective, the soul may be distinguished from the spirit (e.g., I Thessalonians 5:23 and Hebrews 4:12). Though undoubtedly an oversimplification, I would argue from a Christian perspective that soul consists of mind, emotions, and will (aspects not easily attributable to institutions), while spirit reflects a person’s orientation toward the divine (or more generally, the good). Scholars of structural sin might identify a “spirit of violence” or a “spirit of joy” within a human institution. However, even in a Christian theological context, this does not mean that separate ethereal entities are created by human-institutional interactions, and that is not my contention. Furthermore, I am not arguing that there is something eternal about the spirit of Nike or McDonalds. Corporations wind up, sell their assets, are purchased or merged in ways that dissolve the entity or radically transform internal culture as well as their essential orientation toward particular goods. Think, for example, of the purchase of Whole Foods by Amazon and the macro and micro changes in management that followed.

My paper is not meant as an endorsement of any specific contemporary approach to corporate decisionmaking or purpose (though I note several); instead, it is primarily a reflection on Berle’s essay “Corporate Capitalism and the City of God,” wrestling with the question whether corporate managers ought to consider the common good along with or as part of their obligation to act in the best interests of the corporation. To that end, I wanted to bring theological perspectives to the discourse, and I am heartened that the piece has generated some fruitful cross-discipline interest and dialogue.

An abridged case against making it easier for shareholders to sue woke CEOs

As regular readers know, I am not a fan of woke capitalism--particularly when committed by social justice warrior CEOs. But what should we do about it, if anything?

I've heard some folks suggest a federal law making it easier for shareholders to bring derivative suits against directors or officers who inject their corporation into woke politics. I'm sympathetic to the goal, but skeptical of the means.

First, it would represent a further step towards the federalization of corporate law. I address the arguments against expanding the federal role in corporate governance in my book, Corporate Governance After the Financial Crisis at 261-70. The supremacy of federal law and the uniform opposition of Congress and the SEC to private ordering eliminates opportunities for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by federal law precludes experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Likewise, the persistent refusal to accommodate private ordering eliminates solutions from emerging from competition in the market. Instead, the federalization of corporate governance has resulted in rules that were wrong from the outset or may quickly become obsolete, but are effectively carved into stone with little prospect for change.

I would also draw the reader's attention to an older article, The Creeping Federalization of Corporate Law, Regulation, Spring 2033, at 26. In it, I explain that:

The corporation is a creature of the state “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, as the Court noted in CTS v. Dynamics, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.” In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.

According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. . . .

Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. If one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost.

Second, we know that much derivative litigation is meritless. Unless the legislation is extremely narrowly focused, changes intended to “increase stockholder plaintiff’s chances of making it pass the pleading stage” will simply increase the settlement value of such suits. Suppose, for example, in the wake of a tragic mass shooting Walmart decides to stop selling firearms. Do we really want some plaintiff lawyer filing suit against Walmart in that instance? Especially since trial lawyer political contributions primarily go to Democrats?

Third, unless the legislation is extremely narrowly drafted, it will likely involve delegating substantial discretion to a Democrat-dominated SEC.

Fourth, it takes a procedural approach to a substantive problem. A derivative suit is a procedural device mainly used to allow shareholders to bring suit against the firm’s directors and officers for breaching a fiduciary duty owed to the corporation. At present, the sort of woke decisions to which I object almost certainly would be insulated from judicial review by the business judgment rule. See my post Can Tim Cook Ignore ROI When Deciding How to Design an iPhone? So the law would have to create an underlying cause of action.  Which would make the intrusion on state corporate law even greater.

Finally, such proposals are just slapping a Band-Aid on a deep systemic problem. I address the underlying problem in my article Corporate Purpose in a Populist Era at pages 568-577. In short,  I think the rise of CEO social justice warriors resulted from a combination of virtue signaling, the business world equivalent of the Linda Greenhouse effect, and the Ivy League/Upper East Side bubble most of them live in. Most large corporation CEOs these days live in families and social circles where social conservatism is regarded as moronic, retrograde, trailer trash, flyover country nonsense. Acting out as SJWs keeps their spouses and kids off their backs, ensures that the NY Times will say nice things about them, gets their pictures on the society pages, and gets them invited to all the best parties. It lets them hobnob with Hollywood elites and hang out with at Clinton Foundation functions. And it differentiates them from the proles in the GOP base. Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

At somewhat greater length, I suggest that what we’re seeing is the culmination of what Christopher Lasch called The Revolt of the Elites. In his 1995 classic, Lasch identified an emergent split between what he called the New Elites and the rest of society. The changes Lasch spotted became trends that accelerated in subsequent years. In particular, Lasch explained that “the new elites . . . regard the masses with mingled scorn and apprehension.”  They dismissed the masses’ values as “mindless patriotism, religious fundamentalism, racism, homophobia, and retrograde views of women.”  This tension was perhaps nowhere more pronounced than with respect to religion. When Lasch wrote over two decades ago, he opined that “[a] skeptical, iconoclastic state of mind is one of the distinguishing characteristics of the knowledge classes. . . .  The elites’ attitude to religion ranges from indifference to active hostility.”

If anything, today’s elites have become even more hostile to religious values. As Samuel Gregg observes, the Davos Man’s moral creed is “a mélange of social liberalism, environmentalism, and a new order of a borderless world. . . . [R]eligion is considered the refuge of fanatics and anyone stupid enough to be skeptical of gender ideology and techno-utopianism.”

A quarter-century later, Lasch’s new elites have risen to the top of corporate hierarchies. They brought their values into the C-suite. CEOs increasingly reflect the values of the Blue state coastal bubbles in which they are embedded, especially on environmental and social issues. No Fortune 100 CEOs contributed to Donald Trump’s 2016 presidential campaign, for example, but eleven gave to Hillary Clinton. More generally, “liberal groups accounted for eight of the top ten ideological causes of the ultra-rich, and seven of the ten congressional candidates most dependent on money from such people were Democrats.” Even one of the progressive movement’s favorite whipping boys—David Koch—publicly self-identifies as “a social liberal.”

As a result, as a Slate essay observed, “Fortune 500 companies today are socially liberal, especially on areas surrounding diversity, gay rights, and immigration; they are unabashedly in favor of free trade and globalization, express concern about climate change, and embrace renewable energy.” In doing so, they are simply reflecting the changing values of their CEOs.

Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

I'm Puzzled: Board Diversity Lawsuit Against Oracle Tossed on Motion to Dismiss But Not on Failure to State a Claim

Kevin LaCroix reports:

Regular readers will recall that last year and earlier this year, plaintiffs’ lawyers filed a series of shareholder derivative lawsuits against the directors of several companies alleging that the lack of diversity on the companies’ boards breached the directors’ fiduciary duties. ...

The Oracle complaint asserts that the company’s board is “one of the few remaining publicly-traded companies without a single African American director.” The complaint alleges further that the directors “repeatedly made gross misrepresentations in the Company’s public statements by claiming to have a multitude of policies, internal controls, and processes designed to ensure diversity both at the management level and the Board itself.” ...

The complaint asserts claims for breach of fiduciary duty; aiding and abetting breach of fiduciary duty; abuse of control; unjust enrichment; and violation of Section 14(a) of the Securities Exchange Act of 1934.

The defendants filed a motion to dismiss, contending that the plaintiffs had not sufficiently pleaded demand futility and, in light of the forum selection clause in the company’s by-laws, that the plaintiffs’ state law claims must be asserted in the Delaware Court of Chancery. ...

On May 21, 2021, Northern District of California Magistrate Judge Jacqueline Scott Corley granted the defendants’ motion. A copy of Magistrate Judge Corley’s order can be found here.

The court agreed that the state law claims could only be brought in Delaware Chancery Court, reinforcing the power of forum selection clauses. It severed the federal Securities Exchange Act Section 14(a) claims and held they could be dismissed for failure to plead demand futility.

For discussion of the implications of this dismissal and two earlier dismissals in similar cases, go read the whole thing. As usual, it's a detailed and very cogent analysis.

Here's my question: I don't understand why plaintiff framed his Section 14(a) claims as derivative. Since the Section 14(a) implied private right of action was created by the Supreme Court, the law has been that "a right of action exists [under that statute] as to both derivative and direct causes. J. I. Case Co. v. Borak, 377 U.S. 426, 431 (1964). "It is well settled law that a Section 14(a) claim may be brought directly or derivatively." In re Trump Hotels Shareholder Derivative Litig., 96 CIV. 7820 DAB, 2000 WL 1371317, at *10 n.5 (S.D.N.Y. Sept. 21, 2000).

In the Trump case, the plaintiff's suit was dismissed for failure to make demand solely because the plaintiffs were “[p]roceeding in a purely derivative capacity in the right and for the benefit of the Company." Id. Which is what also happened here.

So why didn't the plaintiff in either case bring a direct cause of action under Section 14(a)?

 

Recommended Reading: Russell Powell's new paper Spirit of the Corporation

I read with great interest Russell Powell's new paper Spirit of the Corporation (May 4, 2021). Seattle University Law Review, Vol. 44, No. 2, 2021, Available at SSRN: https://ssrn.com/abstract=3839820.

Abstract: Christian theologians have analyzed the productive and destructive qualities of institutions, sometimes attributing to them human virtues and vices. In City of God, Saint Augustine describes a utopian vision of human community within a Christian context as an alternative to the flawed “City of Man.” Contemporary theologians and sociologists have described collective structures of human behavior in institutions as having a kind of “spirit” analogous to the individual human “spirit.” Institutions are then assumed to take on an existence separate from the individuals within them, and in fact, the “spirit” of an institution influences the behavior of individuals. In The 20th Century Capitalist Revolution, Adolf A. Berle Jr. considers the tradition of religious utopianism and whether corporate capitalism has a spiritual character that impacts communities and individuals for good or ill and whether this might have implications for corporate managers. This Article provides a contemporary theoretical framework for Berle’s insight as a basis for considering its legal and ethical implications for corporate governance. It attempts to unpack contemporary understandings of spirit in order to provide a helpful working definition. It also considers the origins and essential traits of the modern business corporation in the United States, and discusses the question posed by Berle—whether corporations can or ought to have a sort of moral orientation. The Article ponders potential policy shifts that might tilt the orientation of the “spirit of the corporation” toward the common good and considers the limits of legal reform and the role of individuals and subgroups in changing corporate paradigms.

As longtime readers know, I am deeply skeptical of efforts to invest the corporation with a real personality or soul. My primary statement of this view is in my post Is the corporation an entity? With application to the SCOTUS. It elaborates on my favorite quote of all time, from Edward, First Baron Thurlow: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?"

On close examination, however, it seems to me that what Professor Powell is really talking about is not some metaphysical spirit but rather what others might call corporate culture.

Powell states, for example, that "If the spirit of a corporation is formed in part by the institutions that support and constrain them (such as law), then legal change may result in a change in the essence of a corporation beyond isolated behaviors" (389). Compare that statement to these:

• "This corporate culture [of retaliating against whistleblowers] must change, and the law can lead the way." Carnero v. Boston Sci. Corp., 433 F.3d 1, 12 (1st Cir. 2006).
• "If we truly want to inspire long term changes in corporate culture, then we need to think carefully about how we might overhaul corporate and securities laws." Miriam H. Baer, Organizational Liability and the Tension Between Corporate and Criminal Law, 19 J.L. & Policy 1, 14 (2010).

Powell elsewhere quotes Walter Wink's observation that "the spirituality that we encounter in institutions is not always benign. It is just as likely to be pathological." (382) Compare that to:

• "This is not to deny that one might understand calamities like Enron in other ways. Clearly this was a pathological corporate culture ...." David A. Westbrook, Corporation Law After Enron: The Possibility of A Capitalist Reimagination, 92 Geo. L.J. 61, 127 (2003).

Interestingly, in Part V, Professor Powell shifts gears and discusses a number of case studies involving positive or negative corporate cultures using the word culture.

The question then is what do we gain by invoking the concept of a spirit? Powell's conclusion states:

There are strong theological arguments from a variety of traditions attributing a spiritual character to human institutions if not an individual spirit. A purely secular approach could conclude that such institutions have identifiable characteristics and cultures which, though created by human persons and other structures, take on an identity separate from those shaping them that may persist. I assert that both views may be identified as something we may understand as “spirit.”

Professor Powell deploys the concept of spirit to discuss a set of corporations whose "spirit" is oriented towards the common good and those who have a "negative impact" because their "essence has been 'corrupted.'"

I am--as most of you know--a big fan of law & religion scholarship. In this case, however, I'm not convinced invoking the concept of a corporate spirt does any useful work that could not be accomplished by invoking corporate cultures. 

Using Insider Reverse Veil Piercing to Vindicate the Free Exercise Rights of Close Corporation Shareholders

Kent Greenfield and Daniel Rubens want courts to invoke the legal fiction of corporate personhood to frustrate the free exercise rights of close corporation shareholders (although they frame the issue somewhat differently):

Corporations increasingly assert the right to discriminate, based either on free speech claims, religious freedom claims, or statutory claims arising from the Religious Freedom Restoration Act. Such claims have been considered by the Supreme Court in Hobby Lobby (RFRA) and Masterpiece Cakeshop (First Amendment), and in both cases the Court held in favor of the business.

In neither case, however, did the Court address a fundamental flaw with the arguments of the company asserting the speech and religion claims: that the claims depend on the rejection of corporate personhood. The putative religious and speech claims arose not from the beliefs of the companies but of their dominant shareholders. But corporate “personhood” means the interests of the firm are distinct from those of the shareholders. Allowing companies to assert the beliefs of shareholders as their own contradicts established doctrine and risks corporate manipulation of regulations designed to be generally applicable.

Greenfield, Kent and Rubens, Daniel, Corporate Personhood and the Putative First Amendment Right to Discriminate (April 29, 2021). Forthcoming in the Research Handbook on Corporate Purpose and Personhood (Elizabeth Pollman & Robert B. Thompson, eds.,Edward Elgar Publishing),  https://ssrn.com/abstract=3836962

As long time readers know, I am not a far of either veil piercing or reverse veil piercing in its role as a corporate law doctrine. To the contrary, I have urged its abolition as a corporate law doctrine.

But the fact that a doctrine is not fit for one purpose does not mean that the doctrine may not be fit for another purpose.

I believe that insider reverse veil piercing makes sense as a constitutional law doctrine. Indeed, in this context insider reverse veil piercing is the only doctrinal way of deciding when a corporation's shareholders may assert their free exercise rights when the state infringes on those rights by regulating their corporation.

I was prompted to examine this issue by a colloquy between U.S. District Court Judge Reggie Walton and Department of Justice lawyer Benjamin Berwick in Tyndale House Publishers, Inc. v. Sebelius, which was one of the cases that led up to the Holly Lobby decision:

Berwick argued that employers who chose to incorporate their business are precluded from raising First Amendment free exercise of religion-based objections to regulations affecting their business. In response, Judge Walton posed the following hypothetical:

[M]y wife has a medical practice. She has a corporation, but she’s the sole owner and sole stock owner. If she had strongly-held religious belief and she made that known that she operated her medical practice from that perspective, could she be required to pay for these types of items if she felt that that was causing her to violate her religious beliefs?

Berwick replied that the corporation and its shareholders are separate legal persons. The judge thereupon summarized his understanding of the government’s position as being that his wife would “have to go as an individual proprietor with no corporation protection in order to assert her religious right.” Berwick did not contest that characterization.

I find Berwick (and the government's) position on this issue nonsensical. According to Berwick, a sole proprietor could raise a valid free-exercise-based challenge to the mandate, but otherwise identically situated businesspersons who had incorporated their company lose the ability to do so. Talk about elevating form over substance, which often makes sense in a transactional setting but makes no sense when fundamental rights are at issue. Remember we dealing here with a right the Founders expressly embedded in the very first amendment to the Constitution.

Insider reverse veil piercing is the only doctrinal option that allows courts to make the sort of fine distinctions that are at issue here. As I explain in my article, Using Reverse Veil Piercing to Vindicate the Free Exercise Rights of Incorporated Employers (March 6, 2013). The Green Bag, Vol. 16, No. 3, Spring 2013,  https://ssrn.com/abstract=2229414. In it, I assert that:

Invoking RVP in the mandate cases would not be outcome determinative. Instead, it would simply provide a coherent doctrinal framework for determining whether the corporation is so intertwined with the religious beliefs of its shareholders that the corporation should be allowed standing to bring the case.

I proposed a three-pronged version of RVP that should be adopted in the mandate cases:

Is there such substantial identity of the shareholder(s)’s religious beliefs and the manner in which the corporation is operated and the purposes to which it is devoted that the corporation is effectively the shareholder’s alter ego?

How strong is the government’s interest in ensuring that the corporation’s employees get the mandated insurance coverage?

Would reverse piercing this corporation’s veil advance significant public policies?

I elaborated that a court would balance a number of factors:

• Veil piercing is a close corporation doctrine.  In this context, in particular, a public corporation with many shareholders holding diverse views is a poor candidate for RVP-I. In contrast, a closely held corporation – even if quite large by metrics such as assets or employees – with a small number of shareholders holding common religious beliefs is a good candidate. 
• Do the corporation’s articles of incorporation include a statement of purpose referencing religious beliefs and goals? 
• Is the ownership structure of the corporation designed to ensure continuity of its religious purposes even after the original founders have retired or died? 
• Are the directors and officers of the corporation obliged to share the founders’ religious beliefs? If so, are they required to document that fact, such as by signing a statement of faith? 
• Are religious practices such as devotions, prayer, scripture reading, or worship services routinely made a part of corporate meetings? 
• Are such practices made available to employees?
• Is some substantial portion of the corporation’s profits donated to religious charities or otherwise used to advance the founders’ religious beliefs? The biblical concept of a tithe springs to mind here as a possible metric.

The more of these factors that a court finds to be present, the more willing the court should be to treat the corporation as the shareholder’s alter ego.

In Hobby Lobby, no less than 44 corporate law professors--including Greenfield--thought it necessary to file an amicus brief arguing that the essence of a corporation is its “separateness” from its shareholders and that, on the facts of these cases, there is no reason to disregard the separateness between shareholders and the corporations they control. My argument apparently so scared the 44 professors that their brief expressly tackled my argument, asserting that my “argument fundamentally misunderstands the reverse piercing remedy.”

In fact, it was the 44 professors' brief that was replete with errors, overstated claims, or red herrings, and misdirection. I took on the brief in  A Critique of the Corporate Law Professors’ Amicus Brief in Hobby Lobbyand Conestoga Wood (February 21, 2014). 100 Virginia Law Review Online 1 (2014),  https://ssrn.com/abstract=2399638

My article ticked off a lot of problems with the brief, as the table of contents will suggest:

II. The Brief Overstates the Corporation’s Separateness From Its Owners

III. The Corporation’s Separate Existence Does not Always Protect Shareholders from Liability for Corporate Debts

IV. The Brief’s Attack on Reverse Veil Piercing is Overstated and Inaccurate

A. The Brief Misrepresents Hobby Lobby’s and Conestoga Wood’s Argument 

B. The Law Does Not “Strongly Oppose” Reverse Veil Piercing

C. The Brief’s Sleight of Hand Should Not Obscure the Important Policy Issues at Stake

D. The Supreme Court Should Invoke RVP-I to Prevent the Government from Continuing its “Shell Game”

E. Applying RVP-I in the Contraception Mandate Cases Would not be “Disruptive to Business”

1. Protecting the Minority Shareholders’ Interests is Straightforward 

2. The Brief’s Misleading Use of Cede & Co. v. Technicolor, Inc.

F. RVP is not Outcome Determinative 

G. Even Assuming RVP-I Would Give Hobby Lobby and Conestoga Wood a “Competitive Advantage,” They Would not be Alone 

H. RVP-I Will Not Lead to “Disruptive Proxy Contests” 

At bottom, however, my core objection goes to a point Douglas Laycock made that echoed Judge Walton's point:

Laycock observes that:

The threshold issue in Sebelius v. Hobby Lobby Stores and Conestoga Wood Specialties Corp. v. Sebelius is whether any plaintiff’s free exercise of religion is substantially burdened within the meaning of the Religious Freedom Restoration Act.

On that issue, the government’s argument is a shell game. Only the individuals have religious-liberty rights; only the corporations are regulated. And more: Even the individuals have no rights when they act or refuse to act as directors, officers, or managers of the corporation. Not only are the individuals separate persons from the corporation, but the individuals are divided into additional separate persons, depending on the capacity in which they act. This is formalism in the extreme.47

By advancing the same sort of extreme formalism, the Brief provides academic cover for the government's shell game.

In Barium Steel Corp. v. Wiley,the Pennsylvania Supreme Court allowed a RVP-I claim so as to prevent just such a shell game. In that case, the court allowed the plaintiff shareholder (itself a corporation) to pierce the veil in reverse to recover damages suffered by a later-created subsidiary due to a breach of warranty, on the grounds that absent RVP, the defendants would never be liable for their breach due to lack of privity with the sub and the fact that the sub was not an intended third-party beneficiary.The Supreme Court likewise should use RVP-I in this case to prevent just such a shell game.

As I have argued elsewhere, the corporation is not a real entity and to argue the contrary is “transcendental nonsense." The legal fiction of corporate personhood should not stand in the way of free exercise of religious belief by shareholders of a closely held incorporated business.

For more on veil piercing, see:

Delaware Chancery Court (per VC Slights) accepts outsider reverse veil piercing

Thread. But note that Slights is approving only of "outsider" reverse veil piercing. Not "insider" RVP. https://t.co/YhOcbo2QAG pic.twitter.com/xpY7o8Dt3l

— Steve Bainbridge (@PrawfBainbridge) May 25, 2021

On the distinction between insider and outsider reverse veil piercing, see https://t.co/EPFXkMBenm

— Steve Bainbridge (@PrawfBainbridge) May 25, 2021

In contrast, I am willing to accept insider reverse veil piercing at least as a matter of constitutional law. https://t.co/ayPZ4x4aHZ

— Steve Bainbridge (@PrawfBainbridge) May 25, 2021

AT&T Spin Off of Warner is the Latest Turn in the Sad Saga of Paramount Communications v. Time Inc.

In 1989, Time Inc. and Warner Communications, Inc., announced plans to merge. Before the deal could close, however, Paramount Communications, Inc., intervened with a cash tender offer for Time valued at $200 per share. Time responded by recasting the Warner deal as a tender offer and implemented various other efforts to ensure that Paramount would be unable to close its offer before Time could complete its offer for Warner. Since Paramount would be unable to raise funds to buy the combined Time-Warner entity, the restructured deal would put an end to Paramount's intervention.

When Paramount and Time shareholders challenged the restructured deal, Time's management justified its decision on grounds that pursuing the deal with Warner would in the long run produce higher returns to shareholders. As famed Delaware Chancellor William T Allen wrote:

In the longer term, Time's advisors have predicted trading ranges of $159-$247 for 1991, $230-$332 for 1992 and $208-$402 for 1993. ... The latter being a range that a Texan might feel at home on.

Paramount Commun. Inc. v. Time Inc., 1989 WL 79880, at *13 (Del. Ch. July 14, 1989), aff'd, 565 A.2d 281 (Del. 1989).

In a decision I still teach in my Mergers and Acquisitions class, the Delaware Supreme Court held that Time's management had not violated their fiduciary duties to Time's shareholders. Time was thus able to complete its merger with Warner.

Thus began a long and winding road, which the WSJ illustrated as follows:

All of which prompted me to post this tweet:

I wish some finance guru would answer the following question: If you were a #Time shareholder back in 1989 and had held through all the changes, would you be better off today than if they had taken the Paramount deal and you had invested your proceeds in a S&P500 index fund. https://t.co/dKpXSu9NWA

— Steve Bainbridge (@PrawfBainbridge) May 18, 2021

In response to which, a friend reminded me of a 2003 WSJ article observing that:

By now, even schoolchildren know of Time Warner's folly in merging with America Online. However, the story of shareholder value destroyed through acquisition starts much earlier, back in 1989 when shares in Henry Luce's empire, Time Inc., traded for around $100. That spring, Time tried to combine with Warner Communications in what M&A practitioners call a "merger of equals" -- neither party paying a premium for the other's shares. ...

The executives of Time Inc. got to keep their jobs but the shareholders didn't fare so well, particularly with the double whammy of the AOL combination. If you were a shareholder of Time back in 1989 and held your shares through various splits over the years, they would now be worth $113.76 each, about where they were trading more than 14 years ago and far below the Paramount offer. Meanwhile, if you'd just bought the stocks in the S&P 500 index, you would have almost tripled your money.

Meanwhile, I calculated that if you had taken the Paramount deal in 1989 and invested the $200 per share in the S&P 500, you'd have $5,182.69 today. I'd still love to know what those who held their Time shares all these years would have today. I'm betting it's a lot less than $5,000. 

You might think that I'd be critical of the Delaware Supreme Court decision that made all of this loss of value possible. And I am, but not for the reasons you might think. I think the Court reached the right result via hopelessly muddled thinking.

If you're interested, I refer you to my article Unocal at 20: Director Primacy in Corporate Takeovers. Delaware Journal of Corporate Law, Vol. 31, No. 3, pp. 769-862, 2006, available at SSRN: https://ssrn.com/abstract=946016 or my book Mergers and Acquisitions.

In the latter, I explain that:

Time’s defensive actions depended almost wholly on the combined entity’s great size. While the extent of the combined entity perhaps made it unlikely that a subsequent bidder would emerge to unwind the transaction, the possibility existed. The market for corporate control thus could exert some constraining influence on Time’s board, which reduced the likelihood that the board was acting for improper motives, especially in comparison to the defensive restructurings just described.

In addition, it’s critical to the outcome here that Time’s business strategy was motivated by a desire to advance legitimate corporate interests; it had not been cobbled together simply to justify takeover defenses. As a result, Paramount was essentially asking the court to enjoin Time’s board from continuing to operate the corporation’s business and affairs during the pendency of the takeover bid. The Delaware courts were properly reluctant to do so, as a hostile bidder has no right to expect the incumbent board of directors to stop an ongoing business strategy in mid-stream.

In sum, Time presented a highly unusual set of facts, which rebutted the inference that the board acted from improper motives and rendered the result—if not the reasoning—in that particular case relatively unobjectionable.